To repay debt or save, that is the question

Investing

KiwiSaver Q&A: We explore the rules around first time home purchase and the pros and cons of fasttracking the mortgage versus saving

20th Feb 12, 5:44pm by Amanda Morrall

Question: Are we able to use our accumulated KiwiSaver funds subsequent to having bought the home? Second, are we able to use the funds to reduce the capital on a non-commercial mortgage? And third, we're both nudging our 40s, I'm inclined to think that the savings are more important than paying down borrowed capital. Both of us earn well in excess of the average wage, so the mortgage is manageable, we're good with our money, and we're on track to pay it off within 15 years (we owe around $270k). Money in the bank seems a lot more prudent than reducing the capital, but your calculators tell me we will save around $24k in interest payments.

Answer:

Thanks for raising this great question. I'll remind you that I'm not a financial advisor however our new hire analyst Craig Simpson is an authorised financial advisor and I have drawn on some of his knowledge and advice with respect to the latter part of your question.

First the bad news: If you have already purchased your home, unfortunately you can't access your KiwiSavings to pay down the mortgage.

The good news is (and this is of interest primarily to other prospective first time home buyers) is that you can use your KiwiSaver money to finance a non-commercial lending arrangement on a first time home. Provided you have all the supporting documents to prove you are making a first time home purchase, you can arrange to have those funds released to the creditor via a solicitor.

As the procedure can be quite timely, providers caution buyers against putting in an offer to purchase without first consulting them well in advance, and also advising the realtor and solicitors so all parties are on the same page. As this is a relatively new facility, there seems to be some confusion and conflicting information among the parties involved in the transaction. Also, it is important to bear in mind that the money is distributed at the time the house sale goes unconditional. Buyers shouldn't assume that the deposit money can used to hold a house when an offer is made.

On the savings versus debt debate, there are a few scenarios that you may want to consider.

The variables you provided us with are as follows:

$270,000 mortgage
Approximately $35,000 in KiwiSaver funds (excluding member tax credits and kick start)
Monthly mortgage payments of $2,210
Excess monthly savings of $500 a month

If you were to use that extra $500 a month to fast track your mortgage, that would reduce the life of the mortgage by fours years approximately, saving you roughly $35,000 in interest payments.

On the other hand, if you invested that money at the bank on a term deposit that netted you 2.5% per annum (after fees, tax and inflation) you could in 15 years have $127,255.91 set aside. On the face of it, that would seem a slam dunk case for savings versus debt repayment however Simpson said the savings route is riddled with risk for many Kiwis. That's because despite the best of intentions, that money earmarked for savings gets spent on emergencies, travel, incidentals and education cost for children and a host of other unanticipated expenses. So while it may seem more economical to save rather than pay down debt, for all but the most disciplined this is a route fraught with risk It seems far likely likely to get squander if there is a firm agreement in place to repay the creditor.

Another option you may wish to consider is to embark on a hard core savings plan once the mortgage has been repaid prematurely in 11 years and four months by our estimate. By redirecting that mortgage money (plus the $500) into a dedicated savings account earning 2.5% (after fees, tax and inflation), you'll have saved $141,973.46 approximately in four years. Although there same savings risk exist, the short-term frame for banking that money reduces the likelihood of the money getting squandered or used for another purpose.

The bonus for the couple in this case is that they'll also be building their retirement savings nestegg at a much faster rate because they'll have left their KiwiSaver in tact.

Simpson said some issues to consider are your risk appetite, your employment security and a potential increase in the OCR rate if that's what your mortgage rate is tied to. Other risks to consider are the possibility of a market crash, or another global financial crisis.

Having a suitably qualified financial advisor review your circumstances in whole would be a prudent move to ensure your objectives are properly met, said Simpson.

Here's some links that may be useful for first time home buyers?

Housing New Zealand Corporation - for rules on additional home buying subsidies for first homes.

Debt vs saving calculator

Note: These opinions are general in nature and are not a recommendation, opinion or guidance to any individuals in relation to acquiring or disposing of a financial product. Readers should not rely on these opinions and should always seek specific independent financial advice appropriate to their own individual circumstances.

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30 Comments

by Asher | 20th Feb 12, 7:40pm 1329720055

Hi Amanda,

I think your analysis is slightly misleading comparing 35,000 in interest savings to the 127,255.91 in savings (of principal and interest). If you compared both examples at the end of 11 years you would have 86k in savings and still owe 92k on your mortgage vs being mortgage free with the accelerated debt reduction plan ie debt free (my calculations are based on the interest rates I imputed you used).

Also you quoted 2.5% interest rate (after tax and inflation) yet 128k is clearly not based on 2.5% more likely 4.5% which based on their income is a pretty bloody good rate after tax.

Apologies for the negative criticism, otherwise great topic to address.

Regards

by raf | 20th Feb 12, 10:29pm 1329730184

Asher,

Agree that this seems very misleading in the written info. Key quote in the video from Craig is to "pay down your debt as soon as possible".

Paying off the mortgage with the $500 means you are left with 4 years to invest the $500 + $2210 which gives you $142,000 using the 2.5% return........

Paying down your debt provies a risk free return.......unless you think you can beat that return investing, that's the clear winner.

by Bernard Hickey | 21st Feb 12, 11:44am 1329777840

Asher,

Many thanks. Please see Amanda's response below, which points out that debt repayment is 'always' better than deposit saving, but only when you keep saving after you've paid off the mortgage.

Also, have a watch of the video, which goes into more detail and has a strong emphasis on debt repayment as a good thing.

cheers

Bernard

by blok | 21st Feb 12, 6:40am 1329759623

Agreed!

More than slightly misleading too. To anyone less-informed, the $127k of savings would definitely be the way to go.

4.5% is an excellent, unachievable rate in the current climate!

by speckles | 21st Feb 12, 8:19am 1329765550

Not that impressed with the number presentation however must give credit to highlighting the psychology of both options in the video. Self awareness and planning to counter act or work with you own money attitude is just as important as the numbers. In addition, awareness of your partners(family) approach to money needs to be factored in to come up with an effective strategy.

From experience a compromise seems to meet competing demands which you always seem to face in the real world.

by Nesslay | 21st Feb 12, 9:07am 1329768466

I agree that the figures could easily be misunderstood. Please keep it simple.

A simple way of assessing Investing vs repaying debt is to look at the investment return vs the mortgage rate. If the after tax return on an investment is less than the mortgage rate then why bother investing?

If the return is above the mortgage rate then think about the risks of investment (as opposed to no risk when repaying debt). So even if a finance company may be able provide a net return above the mortgage rate, there are very real risks, not only of interest payments but of losing the capital too. Same goes for shares.

I can't think of an investment (other than Kiwisaver with employer contributions) that beats paying down debt. Perhaps that should be the simple message. Mr Key was spot on.

by steven | 21st Feb 12, 10:22am 1329772976

I agree, however even kiwisaver has risk.

regards

by nymbe | 21st Feb 12, 9:27am 1329769657

Are you seriously telling people they would be better off saving at 2.5% rather than paying off debt at nearly 6%?

A mistake or are you deliberately trying to confuse?

by Nic the NZer | 21st Feb 12, 9:48am 1329770923

I think the consensus is that the selected experts should know a little about what they are talking about. I am pretty suspicious of the argument presented myself, as well as the numbers. Its quite possible to have your savings wiped out at least once in any given 15 year period, but I am yet to hear of anybody having their debts wiped out without going bankrupt....

The only advice I ever got was that repaying debt first was probably the best idea, which appears to be another victory for common sense, over whatever this guy is talking.

by steven | 21st Feb 12, 10:21am 1329772883

God how I hate the term 'common sense" However even if what he says is true, its based on the past.....right now we face years if not decades of deflation and depression....so debt today with deflation is a killer, 10% plus per annum as the value of cash increases.......and savings wont be getting 7%.....What I didnt see was an appreciation or risk or how you could lose your nest egg, bank runs in the next few years are a real possibility IMHO let alone a share proce collapse of 75%+ The only reason that has not happened is massive fraud and Govn allowance of same. Paying down debt is the safest way....once its clear use that amount to save....

regards

by Amanda Morrall | 21st Feb 12, 10:44am 1329774279

I would like to clarify a few points that perhaps could have been better worded or framed by me.

Firstly, no we are not suggesting that it is better to save at 2.5% rather than pay down debt, as was suggested above.

The point of this exercise, in addition, to highlighting a little known point about KiwiSaver funds being able to be applied to a non-commercial lending arrangment is simply to outline a few possible scenarios. I think everyone acknowledges that KiwiSaver (and investing in general) comes with risk. It is an investment product and as such is subject to the whims of the markets, economy and a number of other factors.

Just to recap, our calculations found that under the rate of return they were paying on the mortgage through a private lending arrangement they would end up paying $127,6719 in interest over the life of the mortgage. That was based on their current ability to service the mortgage at $2,210 a month.

By saving $500 a month (assuming they could earn after tax, after fee after inflation returns of 2.5% per annum) they could bank $127,255.91. We appreciate there is no guarantee with this rate of return or outcome. When you compare what they could save versus the interest on the mortgage, the difference is apx $500.

The scenario that seems to have been overlooked (and which we outlined above) is that if the extra $500 in savings were used to fast-track the mortgage (reducing the life of it to 11 years and four months) and then a saving plan put into place for four years (the remaining time that they would have been paying down the mortgage) is that there is the potential (at 2.5%) to generate apx $141,900; which is better than saving $500 per month for 15 years at 2.5% (141,900 vs 127,200)

Our personal conclusion is that paying down debt is the most expeditious and financially advantageous position in this particular case, working with the information we were supplied with.

All of this is just food for thought. Everyone's circumstances and financial behaviours will be unique and as such one size does not fit all. As one reader above points out, the psychology of personal finance has a direct bearing on which option might be best.

Amanda & Craig

by Nic the NZer | 21st Feb 12, 11:33am 1329777209

and how should we reason under uncertainty by comparing several 'sure thing' scenarios? Its hardly surprising that investment advice is taken suspiciously when so much of it portrays that 'accidents' never happen, especially when they so frequently do.

by Bernard Hickey | 21st Feb 12, 11:48am 1329778080

Nymbe,

Many thanks. No. See Amanda's response above, which points out that debt repayment is 'always' better than deposit saving, but only when you keep saving after you've paid off the mortgage.

Also, have a watch of the video, which goes into more detail and has a strong emphasis on debt repayment as a good thing.

cheers

Bernard

by dollar_bill | 21st Feb 12, 10:34am 1329773691

Come on - leverage off your existing home and buy a rental property - then another and another - ramp up your debt until you're a millionaire (or appear to be) and own two Bentleys. Can't lose.

Or perhaps leverage off your home and buy gold - it's on a one way trip to the mooooon.

Just kidding - pay off debt and then start saving as per the advice given.

by Nesslay | 21st Feb 12, 11:36am 1329777367

Ahhh... where is the commission on advising a client to pay down debt? Giving the right advice is bad business for a financial advisor.

by FCM | 21st Feb 12, 11:36am 1329777383

I think balance is always good. Here in canterbury there are a large number of people are now wishing all of their money was not locked up in the house, cash flow is very important as well. If they are above average incomes, then I would do a bit of all three, Kiwiwsaver, set some savings aside (for cashflow in case you lose your job/medical etc) this can be offset against your mortgage anyway, and put as much of the rest into your mortgage (while you are on good incomes- as this may not last forever). As they say while the sun shines, make the hay, as the rainy day will come.

by powerdownkiwi | 22nd Feb 12, 9:33am 1329856384

FCM - with respect, Canty was in the path of an approaching wave before the quakes, as was everywhere else.

Beyond peak, investments have to diminish on average (why folk don't get that, is the topic of much discussion in my circles) so the broader you investment spread, the more chance it dwindles in relation to purchasing power. The only way to beat those odds, would be to selectively invest in one/few coy's which stand to do well in the downward phase (like the producers of efficient lighting, appliances etc).

I'm with ChrisJ (I'm not always :) on this one - pay down debt, and as fast as possible. In even themedium term, it's a win. In the long game, perhaps as much as a 50% saving in terms of 'what you have to earn to arrive at a certain point'.

And you're not vulnerable to statistical chance, which says that the longer a particular phase continues, the less time it has to run.

by Chris_J | 21st Feb 12, 12:58pm 1329782314

Bernard, Amanda, Craig

The calculation is flawed because you assume that interest rates will be 5.6%PA for the next 15 years. It also assumes that the payments by the home owner will remain constant, despite inflation and potential income increases (therefore increased ability to make higher payments) over that period.

Also assuming 2.5% net of tax and inflation is on the high side given inflation at even just 2% and a tax rate of 30% (ie 6.42%PA risk free rate when in the same breath you are using a 5.6% mortgage interest rate).

So making a few further assumptions before calculating:

average interest rate of 7.5%PA over the next 2 decades (gross approximation but just for simplicity).
average term deposit rate 5.5%PA over the same period
tax rate on savings of 30%
average inflation over the same period 2%PA
payments increase with inflation
$500 surplus to repay debt increase with inflation too

Coincidentially with the above assumptions it will take 15 years to repay the mortgage without the extra $500/month. After 15 years the savings (an inflation adjusted $500/month) will be $139,806.

Paying the $500 exta off the mortgage each month (incrementally increasing with inflation) would repay the debt in 11 years 2 months. That leaves the opportunity to save the full amount for nearly 4 years which accumulates to $178,325 by year 15, which leaves you $38,519 better off repaying the debt first (as you would expect it too).

I think my assumptions are slightly more realistic (in terms of where interest rates on average are likely to be and that the effect of inflation is taken into account adequately.

Looking at this objectively, the total savings plus the mortgage repaid if you choose the savings first option is $410,000. If you take the debt repayment first option it's $448,000, which means your over 9% better off.

There's absolutely no question that you are better to repay debt first. End of story.

by Chris_J | 21st Feb 12, 1:19pm 1329783583

Incidentially if you expect higher interest rates, then you are even better off to pay the debt first.

Change the assumptions to 8.5%PA average interest and 6.5%PA average TD, then it will take 16 years 10 months to repay the $270k, which means you've saved $175,650 in that time.

If you put the extra $500 (plus inflation) off debt you'd repay in 12 years 3 months, so by 16 years 10 months you'd have been able to put away $236,758 which means you'd be $58,109 better off.

Anyone who saves instead of paying off debt is foolish unless the debt has a very low interest rate (like a student loan etc).

by Amanda Morrall | 21st Feb 12, 1:59pm 1329785941

Thanks for putting another spin on the equation. We're all for paying off debt Chris J. Certainly that's Bernard raison d'etre and I don't think you'll hear him say otherwise.

No one has a crystal ball. OCR could drop just as well too. I'm not concerned about this couple. They are fully armed with information and calculators and most of all an interest in and awareness of their money.

by Chris_J | 21st Feb 12, 2:32pm 1329787957

Amanda, there's really only 2 numbers to consider. A: today's after tax and fees return on the investment and B: today's interest rate on the debt.

If A<B don't consider anything other than paying the debt.

If A>B calculate the risk from (i) the investment and (ii) the likely future interest rate environment. Only if A>B and you are happy with the risk from (i) and (ii) should you save before paying off debt (unless you get a top up like in Kiwisaver in which case you need to do a much more complicated calculation).

Personally I believe that Kiwisaver (even with the Government contributions) is a poor investment for anyone under about 40 with a mortgage - which is why I haven't and won't join Kiwisaver (you could join to get the kickstart then go on contribution holiday but the Govt is short on cash so I haven't done that - and more bureaucratic paperwork is the last thing I want for just $1000).

Paying debt off asap (ideally with a revolving credit facility) is the best method forward.

by stp | 21st Feb 12, 1:05pm 1329782700

Why nobody come with suggestion of paying mortgage debt by reducing its capital. Although in flexible terms it does not matter much, in fixed terms is significantly better. It saves a lot of interest. Apart from the nice looking mortgage account - smaller each fortnight.

by blok | 21st Feb 12, 10:31pm 1329816676

Bernard, Nymbe is perfectly correct!

The narrative argues that savings versus debt repayment is a "slam dunk case" unless the savings are frittered away.

There is no possible way this can be true, let alone a "slam dunk case".

On the face of it, that would seem a slam dunk case for savings versus debt repayment however Simpson said the savings route is riddled with risk for many Kiwis.

by Face Facts | 22nd Feb 12, 4:03am 1329836624

You fullas just don’t get it do you. It doesn’t really matter does it, underlying all these pointless arguments is the fact that modern money today is now rapidly becoming more & more useless as each day passes, save it, spend it, pay off your debt, invest it, burn it, eat it if you like, it makes no difference really, it will soon be shown by simple mathematics that a 10 year old can understand that our entire monetary system is fundamentally flawed & is now in an irrecoverable position.

by Nic the NZer | 22nd Feb 12, 4:16am 1329837376

Your perspective might be a little different, if retaining ownership of your house (or other property) depended on finding some of this 'worthless' money and handing it over to a bank.

by Face Facts | 22nd Feb 12, 4:33am 1329838382

Nic, please expand a little, you point escapes me

by Nic the NZer | 22nd Feb 12, 4:58am 1329839932

Well your description, money becoming less valuable, or essentially worthless, is a characterisation of inflation. What we see happening however is much better characterised by deflation, which is the opposite. Money becoming more valuable, and quite difficult to find. When you have a lot of defaults thats a deflation scenario, because defaults (government, personal, business) are deflationary events.

In fact there is little indication that inflation is in the future, especially with european governments being restricted to 3% deficits. The US government debating if it should breach a self imposed debt ceiling in order to pay its creditors. Most Western governments imposing austerity on their populations. Where is all this new spending power suppost to be coming from anyway?

Anyway the take away point being that this decision could become very important for many people, especially if the deflation scenario is right, because paying off debt ahead of the crowd now, and not when it becomes more difficult to do so, is a good idea in this scenario.

by Face Facts | 22nd Feb 12, 6:44am 1329846240

Thanks Nic,

[ comment deleted - unnecessary vitriol. Last warning. ]

by Nic the NZer | 22nd Feb 12, 7:59am 1329850740

Hmmm, that sounds pretty serious. I am going to call this scenario where people start ignoring the rule of law and using each others property for firewood the zombie apocalypse scenario. I'm not totally disregarding it, but I will be giving it as much preparation as an actual zombie apocalypse scenario with real zombies. But if that changes somebody offered me some good advice recently that the best preparation for a zombie apocalypse is to get yourself an iphone and a burglar alarm. I guess this is so you can see the zombies coming (on your iphone app) and scare them away (with the burglar alarm). Zombies don't like loud waily noises you understand.

I am also a bit confused about this concept of a 6,000 year old ever evolving system, and the idea that you can look at history to understand obviously what is happening today. I thought maybe we could look at history and makes some reasonable analogy and then conclude that the same kind of thing might happen again, but you seem to be saying that you can look at history and make an analogy and then the system evolves (sigh, again) and tricks you because you just thought that was happening but you didn't understand the history, or something. I also can't remember reading about the historic period where the rule of law was discarded in any case similar to what is happening today. In fact my general reading of history has been that society has evolved in a gradually more civilized direction in most cases and over the longer term.

Anyway I think that the world economy is a bit like it was in about 1933, and I reason that something similar is going to happen again. I am kind of going to stick to that until the evolving system kicks in and this stops making any sense.

I do try to have some basis for my beliefs. Maybe I could take your ideas more seriously if you presented some basis (rather than just making prognostications about what is going to happen, without any suggestion of why). If you want to seriously discuss those then that might be constructive, and frankly the label of parasite is pretty offensive for exactly that reason. If you are telling people simply what they should believe without presenting any suggestion of how they should make their own mind up then this forms a very coercive relationship between preacher and deciple. The basis of a non-coercive relationship is to present people with conclusions and arguments to draw them so that they can make their own decisions if they determine to do so. If you really checked a number of my comments you would recognise I choose to present sources quite frequently, and I prefer sources which also meet these criteria.

and no I don't think there is some get rich quick scheme in gold. Like I said deflation a high probability, meaning prices go down, even at some point gold prices. Having less debt based risk is in my books a much better bet that investing in gold.

by skudiv | 22nd Feb 12, 7:51am 1329850278

More evidence kiwisaver has nothing to do with generating wealth, or investing in NZ. If it was you could use the money to invest in your own business. You can however use it to prop up the Auckland property bubble.